June 2025
Our Client Advisory earlier this month discussed various alternatives for awarding equity compensation to employees and other service providers. The purpose of this Advisory is to expand the discussion of Profits Interests (“PIs”).
PIs have been around for years, since the IRS sanctioned their use in a 1993 Revenue Procedure. However, the explosion in the use of limited liability companies (“LLCs”) as the vehicle of choice for many start-ups has carried with it a corresponding increase in the popularity of PIs. Profits Interests can only be issued by entities treated as partnerships for federal income tax purposes. As a practical matter, that is typically an LLC with two or more members.
PIs have a number of advantages and a few disadvantages, but they can be a bit complicated to understand. PIs represent an equity interest in the company issuing them. However, one of their primary advantages is that, if properly structured, the issuance of a PI to an employee or other service provider is not subject to any current income tax liability for the recipient. The reason is that a PI has no ascertainable value at the time of issuance because the recipient is not permitted to participate in any appreciation in the value of the company’s assets or profits that accrued before the date the PI was issued.
For example, assume the company has assets worth $1 million with a nominal tax basis at the time it issues a PI to a key employee. If those assets are later sold for $5 million, the holder of the PI is permitted to participate in $4 million of the post-grant appreciation in the company’s assets, but may not participate in the $1 million in pre-grant appreciation. For that reason, valuation of the company’s equity at the time of grant is important, and understating that value to potentially increase the economic return to the employee could disqualify the PI from favorable tax treatment. A future sale of a PI by the recipient is generally taxed at favorable long term capital gains rates, assuming the requisite holding period is met.
Despite the limitation described above, PIs can provide a substantial economic benefit to service providers, particularly when issued by early-stage companies. The other attribute of a PI that can be viewed as a disadvantage is the fact that the recipient of a PI becomes an owner of the company issuing the PI. This means that payments to the recipient for services rendered are no longer subject to payroll withholding. Instead, they are treated as guaranteed payments under Section 707 of the Internal Revenue Code, which in turn requires the holder to file estimated tax on a quarterly basis.
If we can provide any additional information, please contact Bill Miller at wmiller@bizlawma.com.
This memorandum is intended to provide general information of potential interest to clients and others. It does not constitute legal advice. The receipt of this memorandum by any party who is not a current client of the Business Law Group does not create an attorney-client relationship between the recipient and the firm. Under certain circumstances, this memorandum may constitute advertising under the Rules of the Massachusetts Supreme Judicial Court and the bar associations of other states.